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Mutually Speaking

What is an Annuity?

An annuity is a vehicle for managing long-term income. The owner makes an initial investment when purchasing the annuity, in a lump sum or a series of payments. In return, usually after the purchase price is fully paid, the annuity pays out to the owner on an agreed-upon schedule, immediately or at a later time. Life insurance companies offer various types of annuities:

Fixed annuities pay out a guaranteed amount based on the face value of the annuity and interest accrued. These investments are popular with conservative consumers who want to lock in a return.

Indexed annuities are fixed annuities that provide a guaranteed minimum payout while tying a portion of the payments to the performance of a market index like the S&P 500. These annuities are popular with investors who want a greater upside potential coupled with a guaranteed return if the tracking index goes down.

Variable annuities usually provide a somewhat higher return, but are accompanied by greater risk. The amount of payments is based on the performance of investments underlying the contract. Most variable annuities are sold with a Guaranteed Minimum Benefit Rider or Guaranteed Minimum Withdrawal Rider. These riders mitigate downside investment risk and but come with additional fees.

Annuities receive favorable tax treatment that can make them an attractive investment. Under current law, interest on the annuity balance grows tax-free until it’s paid out. Annuity payouts are taxable as ordinary income but, since payments are usually deferred until after the owner retires, they’re often taxed at a lower rate than they would have been while the owner was working. Unlike contributions to 401(k) accounts, however, buying an annuity doesn’t reduce the owner’s taxable income.

Annuities usually come with surrender charges that apply if the owner cashes in the annuity ahead of schedule. These surrender charges are normally waived in the event of the annuitant’s death. Most annuities also have a fee-free withdrawal provision that allows the owner to withdraw a certain amount each year without incurring any early withdrawal fees.

Is an annuity right for me? Depending on your financial situation and retirement goals, an annuity can be a good investment. Talk to your financial advisor before buying an annuity, and shop carefully to avoid excessive fees and surrender charges.